Credit Rating Process – There are only two ways in which any company would fund its business – equity or debt. The equity portion of the capital structure could be derived broadly from three sources: Promoters investing in the business, Company’s internal cash flows accruing over the years to equity, or IPO (Initial Public Offering)/FPO (Follow-on-public offering) for which a company taps different financial markets.

Out of the three, only the last step of the equity source i.e IPO/FPO require the attention of large banks and broker houses, who capture the equity valuation of the company and drive the process. On the other hand, any form of debt issuance demands validation from a credit rating process. Of course debt being cheaper than equity, companies quite frequently and on an ongoing basis, issue debt (and repay the same eventually), which means credit rating process of a company plays a major role in its debt raising capacity.

Why Companies Opt for Credit Rating?

Let us assume that Teva Pharmaceuticals Industries Ltd (or “Teva”), an Israel based world’s leading generics pharma company plans to set up a manufacturing unit in the US to manufacture its drugs for the US market. To fund this capital expenditure, suppose Teva plans to issue a bond in the US market or a bank loan from Morgan Stanley. Of course the creditors would like to evaluate Teva’s ability to repay its debt (also called as the credit worthiness of the company). In such a scenario, Teva may ask a credit rating agency, say Moody’s to assign them a credit rating, so as to enable them to raise debt. A non-rated company (bringing in the fear of unknown for the creditors) would on the other hand face issues in raising debt compared to a company rated by an external credit rating agency. The credit rating of a company helps the creditors to price the debt instrument for the company with reference to the amount of credit risk that the creditors would be taking.

Significance of Credit Rating

Now let us understand what the credit rating signifies.

A credit rating determines the probability of the company paying back its financial indebtedness within the stipulated time. The ratings could be assigned to a particular company, or could also be issue specific.

Below is the chart illustrating the credit ratings scale from the global credit rating agencies – S&P, Moody’s, and Fitch. To be noted that Indian rating agencies ICRA, Crisil, and India rating and research are Indian subsidiaries of Moody’s, S&P and Fitch, respectively. The long term ratings are usually assigned to a company, while the short term ratings are essentially for specific loans or debt instruments.

The topmost ratings in the above chart signify the strongest companies financially.

The long term ratings from Aaa to Baa3 in case of Moody’s and likewise in S&P and Fitch qualify as investment grade, while the companies rated below Baa3 fall under non-investment grade category (which have higher probability of default).

An investment grade company is typically characterized by low levels of leverage (Debt/EBITDA) and capitalization (Debt/Total Capital), strong liquidity (i.e ability to service its financial obligations), strong business profile (with leading positions in their respective markets), strong cash flow generation, and low cyclicality.

Of course given the lower risk involved to lend an investment grade company, the cost of debt for such companies would be low compared to a non-investment grade.

Likewise, the cost of debt is higher for a company rated at Ba3 compared to a Baa3 rated company. No points for guessing that companies aim for an investment grade rating so as to reduce the pricing in which they are able to raise loans from the bank or bonds from financial markets.

Credit Rating Process: Teva’s Example

Coming back to Teva, who approached Moody’s to assess its credit rating. With the receipt of this request, Moody’s assigns a credit rating (typically through a couple of weeks long process) to Teva. Let us think about some of the factors that Moody’s would look at for assigning a credit rating to Teva.

Moody’s industry expert analysts would perform credit rating process, a detailed analysis of Teva broadly based on the following factors:

#1 – Business profile

The very first thing that the analyst would do is to understand Teva’s business profile, its competition, core products, number of employees, facilities, clients etc.

#2 – Operating segments and industry standing

Teva operates in two broad segments comprising: 1) a portfolio of generic drugs (i.e copycats of drugs of which patents have already expired), as well as a 2) modest product pipeline of originator drugs (which have live patents).

Moody’s would analyse each of its operating segments and their respective market positions. Teva has a strong generics product pipeline, which derives most of its revenues from the US and Europe, and has leading positions in these developed markets, which are already encouraging growth of generics.

The Obamacare act in the US, which increases the insurance coverage of the US citizens would really like to focus on reducing their healthcare costs, while the European markets would aim to reduce healthcare costs too (owing to the ongoing difficult macroeconomic conditions), by increasing usage of generics.

On the other hand, the branded segment is subject to competition from generics (post the patent expiries of its drugs). In fact, Teva’s sclerosis (a disease pertaining to hardening of tissues) therapy drug Copaxone, which represents ~20% of its revenues is facing the same risk!

Copaxone’s one version of the drug has already expired, which means that cheaper generic drugs of the same branded could be launched in the markets, thus impacting Copaxone’s market position significantly.

#3 – Business risks

Moody’s would look at each of its product segments and also see the kind of future portfolio (characterized by the type of their R&D expenses) that Teva plans to launch in order to cover the loss in sales from the expiring drugs in the branded portfolio.

Further, Moody’s pharma industry expert would analyse all the industry specific factors such as litigations in which Teva is involved and their materiality in terms of probable financial impact, and regulatory risks in terms of US FDA inspections of its facilities (to be noted that US FDA demands the highest quality of manufacturing practises for the pharma companies selling their products in the US).

Additionally, concentration risks related to a particular product (where difficulties in one product could impact the company financially), a particular supplier (where a supply issue could impact its sales), and a particular geography (where geopolitical issues could arise) would need to be analysed separately on a company and industry specific basis.

#4 – Historical financial performance

In this, an analyst would go about analyzing the historical performance of the company. Calculating Margins, Cash Cycles, growth rates of revenue, Balance Sheet Strength etc.

#5 – Scale and margins compared to its peers:

Teva is the largest generics company and one of the top 15 pharmaceuticals firm in the world. Teva generated annual revenues worth ~USD20 billion in financial year ending 31 Dec 2015 or “FY15”, which indicates the high economies of scale of the company.

Teva’s EBITDA margin (~24% in 2015 on an EBITDA of ~USD4.7 billion) is among the highest in the world. It is another topic of discussion that different rating agencies could come up with different EBITDA calculation depending on whether they include or exclude litigation charges (which could be considered operating in nature in case of pharma companies) or restructuring charges (which could be really ongoing in nature and may not make sense to exclude from EBITDA).

Anyways, coming back to Teva, the company’s leading margins and scale could really help derive itself great brownie points from Moody’s.

#6 – Revenue and margin drivers in the past, and their sustainability:

As mentioned earlier, Copaxone patent expiry would significantly drive the revenues and margins down for the company in the coming years and Moody’s would need to analyse, how the company’s future product pipeline would cover the loss.

However, we note that Moody’s would nevertheless derive comfort from its leading position in the generics segment.

#7 – Cash flow generation capability:

A company’s cash flow generation and its stability is an important parameter to look at.

Teva’s cash flows must be enough to service its debt (i.e principal and interest payments), capex and dividends.

We note that a company with shareholder friendly policies like high dividend payout ratio (i.e dividends/net income) would be less liked by the credit rating agencies, as the creditors would rather like the free cash flow to be utilized for debt repayments than dividends/share buyback

#8 – Balance sheet analysis and liquidity profile:

Moody’s would be keen to see the amount of dispensable cash that Teva has, which is required to fund its working capital requirements (related to product inventories ahead of the new launch and receivables from the pharmacies).

Debt maturing in the shorter term would require more of caution, as the debt amortization payments could actually impact its ability to undertake day to day operations as well as could hurt its expansion plans.

Teva had total debt of ~USD10 billion as at FYE15, which may sound huge; however on an EBITDA of USD4.7 billion, the gross leverage ratio (Gross debt/EBITDA) came to 2.1x, while the net leverage (Gross debt-Cash/EBITDA) came to a low 0.7x, which indicates a relatively strong financial profile.

#9 – Financial ratios and peer analysis:

Ratio analysis is the basic and effective way of comparing companies within the same industry.

Rating agencies would typically compare the pharma companies of similar scale with comparable business profiles with the company it is expected to rate.

Consequently, Moody’s would compare Teva’s margins, leverage, debt service coverage ratio, interest coverage (EBITDA/ interest expense), and gearing (Debt/(Debt+Equity)) with that of its competitors (which also could be rated by them) and arrive at an estimation of strength of Teva’s financial profile.

Credit Rating of Teva

Moody’s would assess the credit rating process, its profile and subsequently the ratings of Teva with respect to different weights assigned to different parameters as described above (both financial and business). Of course if need arises, Moody’s could also visit Teva’s manufacturing facilities and meet with the management to perform its due diligence (to evaluate Teva’s actual commercial potential). For issue-specific ratings, Moody’s would also analyse the quality of collateral provided by the Company for a particular instrument.

We note that the rating that Moody’s came up with Teva’s inherent profile was A3 as of Apr 2015.

However, we note that Moody’s downgraded Teva by one notch to Baa1 in Jul 2015 and another notch to Baa2 in Jul 2016.

Let us see what drove Moody’s to downgrade Teva by two notches within a year.

The first downgrade was based on Teva’s announcement in Jul 2015 to acquire the generics business of Allergan for USD40 billion.

While a portion of this acquisition was to be funded by equity, this acquisition required Teva to raise a lot of debt on its balance sheet, leading to leverage ratio of 4.3x on a proforma basis (i.e including the EBITDA and debt of the acquired entity).

Hence, the one-notch downgrade was driven by the increase in financial and integration risks, due to significantly higher indebtedness, however also considering the company’s improved scale with the acquisition.

The second downgrade was driven by completion of the acquisition and the higher proforma leverage ratio of 4.7x, as well as sales erosion owing to patent expires of Copaxone.

Conflict of Interest Between Rating Agencies and Companies

You may wonder if there exists a conflict of interest between rating agencies and the companies paying them for the ratings.

It may seem so, given that Teva is actually a source of revenue from Moody’s. After all, rating agencies actually earn only from companies which they so closely and critically evaluate!

However for a rating agency, their credibility is of utmost importance.

If Moody’s would not have downgraded Teva based on the significant increase in debt post the acquisition of generics business of Allergan, it would have lost the trust from the creditors, and would not have valued Moody’s opinion going forward.

Once the credit rating agencies are subscribed to by the companies, they need to periodically monitor the company’s ratings based on new developments in the company (like seen in the above case with Teva’s announcement of acquisition), as well as any updates related to the industry (in Teva’s case pharma), regulatory changes, and peers.

Conclusion

In conclusion, creditors rely heavily on the credit rating agencies for lending at a particular price for the risk-reward ratio. Hence, the rating agencies need to ensure fairness of opinion, hawk-eyed approach for probable developments in future, as well as unbiased credit ratings for a company they are evaluating. In various cases of corporate lending, the banks themselves conduct credit analysis, as they may not want to rely on external credit agencies and rather form their own view on the credit of a company. However, as seen in the recent cases of increasing NPAs (non-performing assets) coming to light in India, banks need to be all the more cautious while lending to corporate.